Gross Profit Percentage

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Determining the efficiency performance. Explanation of Gross Profit Percentage.


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What is the Gross Profit Percentage? Description

The Gross Profit Percentage is a ratio which can be derived from an income statement. GPP reveals the resulting profit from operations after all variable costs have been subtracted from revenues. It can be used for determining the efficiency of the performance of a company, because it shows the production efficiency in relation to the prices and unit volumes at which products or services are sold.

 Gross Profit PercentageComparison of the Gross Profit Percentage ratio

This provides the most meaningful information. For example:

  • Comparing the Gross Profit Percentage ratio with an industry average (ensure the method used of calculating the industry ratio is the same). This provides an indication of whether the company is performing better or worse than the industry as a whole. The comparison is useful for obtaining a preliminary knowledge of the company's business.

  • Comparing the Gross Profit Percentage between different divisions within an entity. This comparison indicates which divisions may require further investigation. The comparison is useful for obtaining a detailed knowledge of the company's business.

  • Comparing the Gross Profit Percentage over time. For example: comparing this year with last year. An increase in the ratio over the previous year may be an indication that cost of sales is understated (including, for example, an overstatement of closing inventory) or that revenue is overstated; a decrease may indicate that cost of sales is overstated or that gross revenue is understated. (Where monthly figures are available, an examination of the ratio for the last two months of the financial year could assist in highlighting any adjustments made to revenue and cost of sales at year end.) In many instances, however, a change in the ratio is caused by a change in production methods, product mix, or some other legitimate reason.

Gross Profit Percentage ratio calculation

A common Gross Profit Percentage ratio calculation goes as follows: Add together the costs of overhead, direct materials and direct labor; subtract the total from revenue; and then divide the result by revenue. A problem with this approach is that many of the production costs are not truly variable.

In order to avoid this, you can use another calculation formula, which only includes direct materials in the formula, shifting the other production costs into operational and administrative costs. This obviously yields a higher gross margin percentage.

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